Gap Shares, YTD, Rise 80%: Reborn Growth Stock or Gaudy Value Play?

by Suzanne McGeeNovember 09, 2012

A tug of war is taking shape over the future outlook for Gap Stores (GPS) between investors. Some of them set the seal on their above-average returns for the first nine months of 2012 by unloading their shares in the retailing turnaround stock of the year. The company’s stock price, after all, has soared more than 80% since the beginning of January, having coming close to doubling, making it one of the best-performing stocks in the S&P 500. Is this just another value-versus-growth debate, or are there other signs that Gap’s remarkable recovery may be sputtering?

Certainly, Gap’s revenues, net income and gross margins also have been on the upswing this year, culminating a turnaround that began with a management shakeup. The company has been closing stores in the United States, rationalizing the number of outlets after a period of overexpansion, while increasing its global presence. It made a foray into China and is contemplating doing the same in India.

A big part of that blockbuster performance is due to the company’s ability to nail key fashion trends. Its Banana Republic division launched its “Mad Men” collection to coincide with the return of the hit cable television series to the air; Gap’s introduction of vividly-colored denim early in this spring quickly turned these garments into “must owns” for 2012.

Together with tougher oversight, this ability to capture the fashion zeitgeist has helped the company improve its inventory management. Over the last five years, inventories have come down sharply to about 69 days worth of merchandise, well below year-ago levels north of 80 days.

Gap has reported a series of strong gains in same-store sales, climbing 6% for the third quarter, far ahead of much of the rest of the retail university. That led the company to inform investors that it expects to announce an 8% increase in net sales for the fiscal third quarter, which ended October 27, and to beat analysts’ earnings expectations by reporting earnings of 61 to 63 cents a share.

With all that good news, why are some value investors walking away from Gap Stores? The answer lies square in the rapidity of the run-up in the company’s valuation -- based on PE ratio -- over the course of the year, which has outpaced that of many of its rivals.

Clearly, Gap has made the leap from being a value stock on the verge of or in the midst of a turnaround, into a growth stock, whose future share price gains are likely to hinge on its ability to outperform in terms of same-store sales, revenues and profits – as well as its ability to stay ahead of the fashion trend. (Currently it is betting that shoppers will develop as much of a passion for colored corduroy as they showed for colored denim.) With that in mind, it’s notable that Gap will be opening its stores for the annual Black Friday sale on Thanksgiving Day itself.

As long as the company can manage to avoid over-discounting its merchandise during the holiday shopping season and stay on pace with respect to its inventories, sales and profit margins, the stock may well remain a key holding for growth investors. For value-oriented investors, however, the biggest gains may already have been recorded, with the risks associated with the run-up in valuation now dominating.

Suzanne McGee is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.